Auditing State Secrets in China

by Professor Bing LingCSC academic group: Law and Business

Bing joined the Sydney Law School as Professor of Chinese Law in September 2012. Before coming to Australia, he was a professor and founding member of the Faculty of Law of the Chinese University of Hong Kong. He is the author of books and articles on Chinese civil and commercial law and international law, including Contract Law in China (Sweet & Maxwell Asia, 2002). He was admitted to the Bar of PRC in 1990 and served as an expert witness on Chinese law questions in numerous international litigation and arbitration cases.

In August 2012, the Securities and Futures Commission (SFC) of Hong Kong brought a lawsuit against a major international audit firm, Ernst & Young Hong Kong (E&Y), for its repeated refusals to produce certain accounting documents to SFC that stemmed from its work for a mainland China-based company called Standard Water. Standard Water had applied for listing at the Hong Kong stock exchange in 2009, but withdrew its listing application in 2010 after E&Y abruptly resigned as its reporting accountants and auditors upon discovery of “certain inconsistencies” in the company’s documentations. When SFC started to investigate into possible misconduct in the matter, E&Y refused to comply with SFC’s request for audit documents, citing requirements under mainland Chinese law to protect state secrets. The case, which will have its hearings next March, is the first of its kind in which the Hong Kong regulators have asked the Hong Kong court to rule on the claim of mainland state secrecy and to compel the audit firm to comply with SFC’s investigation. 1

While the case against E&Y ìn Hong Kong attracted media attention internationally, it emanated from a broader context which has seen a growing number of China-based audit firms and companies raising China’s state secrets law as a ground to refuse requests by regulators outside China to investigate or inspect their audit documents.

While the case against E&Y ìn Hong Kong attracted media attention internationally, it emanated from a broader context which has seen a growing number of China-based audit firms and companies raising China’s state secrets law as a ground to refuse requests by regulators outside China to investigate or inspect their audit documents. These attempts are seen to threaten the proper oversight of audit quality, the importance of which to investor protection was understood almost as long ago as the inception of modern capitalism itself. The need to ensure accurate and independent audit work on public corporations was most painfully felt in the wake of the massive financial and accenting scandals involving Enron and WorldCom at the beginning of the last decade. That led in the US to the adoption of the Sarbanes-Oxley Act in 2002 which created the Public Company Accounting Oversight Board (PCAOB) to impose external oversight of all auditors of companies listed in the US stock market. Many other countries (including Australia) have developed regulatory systems to the same end.

With China’s emergence as a major world economy, an increasing number of Chinese companies have entered overseas capital markets in the past decade through initial public offerings or through merging with existing listed shell companies (reverse mergers). Meanwhile, many major western companies developed extensive operations in China, and the China-based affiliates of the global audit firms networks (such as E&Y) began to play a growing role in the consolidated audits of those companies.2 In fact, about 100 China-based audit firms are now registered with PCAOB, making it the largest foreign country group in the US market. But, in the past few years, a substantial number of financial frauds and accounting failures have begun to come to light. In the US alone, since late 2010, 67 China-based issuers have had their auditors resign and 126 companies have either been delisted or have stopped filing regular reports with the US regulators.3 Investigations by the US regulators into Chinese affiliates of international audit firms such as Deloitte have been met with resistance based on China’s state secrets law. 4

The legal definition of state secrets includes not only matters such as secrets on state affairs, national defence, diplomacy and criminal investigation, but also “secret matters on national economy and social development” and information disclosure of which may “affect national unity, ethnic solidarity and social stability”, “damage the state’s political or economic interest in external activities”, or “weaken the state’s economic and technological strength”.

In fairness, China is not the only country that has objected to foreign oversight of its audit firms. Several European countries have not cooperated with inspections by the PCAOB owing to data protection concerns under EU law. In China, the main obstacle is a joint regulation issued jointly by three governmental agencies in October 2009, which affirms that audit papers and documents of Chinese companies listed overseas may involve state secrets or state archives, in which case they must not be disclosed to foreign regulators or moved outside China without approval by the Chinese government, and any entity or individual that violates the law protecting state secrets and archives may be subject to criminal prosecution.5 The major problem of Chinese law in this area that has been the target of vociferous criticisms by human rights researchers and activists is the overly broad and vague definition of state secrets.6 The legal definition of state secrets includes not only matters such as secrets on state affairs, national defence, diplomacy and criminal investigation, but also “secret matters on national economy and social development”7 and information disclosure of which may “affect national unity, ethnic solidarity and social stability”, “damage the state’s political or economic interest in external activities”, or “weaken the state’s economic and technological strength”.8 Given the wide-ranging and open-ended character of the legal definition, it is not inconceivable that audit papers on a major state-owned corporation may involve information that borders on state secrets – remuneration for senior officials is a plausible example. Chinese criminal law includes several provisions that prescribes severe punishment (including death penalty in exceptional cases) for violations of state secrets protection. An audit firm that is caught in the unenviable position of having to comply with potentially conflicting demands of different governments finds itself in a situation not dissimilar to the Swiss bank forced by the US tax authorities to disclose client information considered almost as sacred and inviolable under Swiss law.

There are a number of ways to resolve the conflict problem. Although the lack of specific and operative standards for determining state secrets is often seen as a crucial problem, improvement of Chinese secrecy law probably would not do much to address the current problem, as the conflict could arise wherever two legal systems make competing demands on the same matter. The optimal approach would be an international agreement, of the same kind as the PCAOB has with 14 foreign regulators (including Australia), that allow for joint inspections of non-US audit firms in foreign territories or shared inspection findings between the parties. Chinese law permits audit papers to be disclosed to overseas regulators even if they include state secrets, so long as the relevant government authorities consent. In September 2012, China agreed to allow American regulators to observe auditor inspection in China, which is widely seen as a first step toward potential joint inspections of Chinese audit firms.9

A less desirable approach would be unilateral sanctions on the offending auditors. The American PCAOB has threatened revocation of registration of non-complying foreign audit firms, thus shutting them out from working for US-listed companies.10 In the case of Hong Kong, the issues confronting the Hong Kong court in the E&Y case may not merely be an interpretation of the Hong Kong statute, but also the determination of the legal effect of mainland state secrets in Hong Kong. Thorny political issues could emerge if the governments concerned fail to agree on a cooperative approach to deal with the problem.